Roth IRA vs. Traditional IRA

Vicente J. Gonzaga Erl Malboeuf Team 6 Roth IRA vs. Traditional IRA

Overview • What are IRAs? • Roth vs. Traditional • The Scenario • Analyses and Comparisons • Conclusions

What are IRAs? • IRA = Investment Retirement Account • Specialized savings accounts specifically geared for post-retirement funding • Tax features • Tax-deductible • Tax-deferred • Tax -free

Choices, Choices • So why are we up here? • IRAs come in two main flavors: • 1) Traditional • 2) Roth • Which one?

Roth vs. Traditional • Traditional IRA • Contributions are tax-deductible • $75,000 gross salary • Deposit 10% ($7,500) into a Traditional • ($75,000 -$7,500)=$67,500 (new gross income) • Cool beans, right?

Traditional IRA • Contributions are tax-deductible, but withdrawals are taxed based on the income bracket they fall under • Traditional IRAs • Tax-deductible contributions • Tax-deferred balance growth • Taxed withdrawals/distributions

Roth IRA • Roth IRA • Contributions are not tax deductible • $75,000 gross salary • $75,000 – [25%($75,000)]=$56,250 • THEN deposit 10% ($5,625) into the Roth IRA • $5,625<$7500 (from Traditional) • Ew… right?

Roth IRA • Contributions are made with after-tax dollars, but withdrawals are tax-free. • Roth IRA • Contributions based on after-tax dollars • Balance growth is tax-free • Withdrawals/distributions are tax-free

Roth and Traditional • Important fact to keep in mind: • Both Roth and Traditional IRAs impose contribution caps (equal for both) • Caps are adjusted for inflation every few years. • For simplicity, we treated cap adjustment as continuous • These caps greatly affect the dynamics of the savings plan given initial conditions.

The Pitch • You are Yoda (you can live for a very, very long time). • You have used the force to earn an engineering degree and have landed a position with $60,000 gross annual pay “Long, I live.”

Major Assumptions • Deposits will always be a fixed percentage of available income • “Excess” savings (explained later) will go into market investment • We later neglect “excess” • Assumeno pension • Tax brackets always apply where appropriate

Default Values • Starting Gross Salary: $60,000 • Expected Annual Raise=8% • Annual deposit rate: 10% • Applies to available income • Deposits between accounts are not equal • This is strictly followed • Post-retirement Lifestyle: $65,000 • Total years employed: 41

Default Values • Inflation: 3.5% • IRA Caps increase by inflation (=3.5%) • Interest earned on both IRAs: 5% • Market ROR: 9.00% • Retirement Assets ROR: 6.00%

The Reference Parameter? • Debt-free years after retirement! • How long under each account given equal conditions will you last after retirement?

Our Goal • UNPRECEDENTED , NEEDLESSLY METICULOUSL ACCURACY • (Flip to excel file and previous presentation on similar topic)

Assumptions Made (from a past class’ presentation) • Equal contributions to both plans • Roth IRA ineligibility ignored • Flat tax (not tiered) • Annual salary raises kept up with inflation at 3% • ROR is 10% • No 401K matching from employer • No Social Security Benefits • No investment fees • 35 working years

Excess Included

So Far… • It looks like Traditional IRA is the better choice- • But is this the whole story? • Remember that we’ve been including excess savings (that have been invested with an ROR of 9.00%) • Let us now neglect excess savings

Excess Is Neglected!

The Tables have Turned! • So what just happened? • Excess Included => IRA wins • Excess neglected => Roth wins • Which one really wins? • The answer lies in the circumstances, and may change according to certain factors blahblahblah…

BASICALLY • It depends! • Traditional IRA “won” with excess • This implies that the Traditional IRA allows for more flexibility with extra savings! • Roth IRA “won” when excess was neglected • This implies that between the two, Roth IRA has the longest staying power based purely on account withdrawals!

The Bottom Line • The Roth IRA is the safer option for people who choose to invest extra savings minimally. If left to account balance alone, the Roth will outlast the Traditional. • People who tend to rely on earned interest and surefire, small investments should choose the Roth.

The Other Bottom Line • The Traditional IRA allows for creative use of large excess savings but does not have as much post-retirement staying poweras the Roth. It is therefore slightly riskier. • People who are more confident investors and are investment-savvy may benefit more from a Traditional IRA, or may find the Traditional more appealing.

Roth IRA vs. Traditional IRA